Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

Republic of Croatia—2006 Article IV Consultation

Preliminary Conclusions
November 8, 2006

1. As the Croatian authorities recognize, maximizing success in the transition process requires progress on several fronts. The experience of the new EU members shows that fast convergence toward the EU income level requires both macroeconomic stability and productivity growth. The first is founded on low inflation and fiscal discipline. The second stems from a business-friendly environment that safeguards market competition and promotes private sector investment. "Greenfield" foreign direct investment (FDI) has played a key role in the top performers, not only in boosting the physical capital stock but also in bringing technological know-how. It is reassuring that the authorities' economic aspirations as described in the Pre-Accession Economic Program, the Economic and Fiscal Policy Guidelines, and the Strategic Plan for the Economic Development of Croatia are consistent with this experience.

2. Croatia has already had its share of successes in recent years. Growth has been solid and CPI inflation contained. The authorities, since 2004, have put the fiscal deficit on a downward path, improved transparency and budgeting processes, and reduced quasi-fiscal activities. Meanwhile, steps were taken to bring the pension and health care systems closer to sustainability, and financial sector supervision has been strengthened. Looking ahead, the beginning of EU negotiations and the successful completion of the screening process have boosted investment prospects. Absent negative shocks and slippages in macroeconomic policies, economic growth for 2007 and the medium term should remain solid, albeit lower than the highs of recent years. Meanwhile, inflation is expected to remain in check.

3. That being said, a deteriorating current account deficit in recent years and a high level of external indebtedness leave no room for complacency and underscore the importance of continuing the fiscal consolidation effort. The current account deficit is expected to be above 7½ percent of GDP this year, with a clear risk that it will be even larger next year. At the same time, Croatia's gross external debt is high at over 80 percent of GDP. The large external imbalance leaves the economy exposed to external shocks, potentially accentuated by an expected sharp drop in privatization-related inflows after 2007. Moreover, a change in investors' sentiment toward emerging markets could lead to debt rollover and debt service difficulties. Being well aware of these risks, the government and the Croatian National Bank (CNB) stepped up efforts to mitigate them in recent years. However, with elections in 2007, there is also a well-recognized risk of policy drift and rising populism in the formulation of fiscal policy.

4. While the mission would like to see Croatia's economic growth increase to a sustainably higher rate, the state's presence in the economy, slow progress in key structural reforms, and less-than-satisfactory conditions for doing business hold the economy back. The state's presence in many aspects of economic activity remains significant and is reflected in one of the biggest governments in the region, high state aid in various forms, and a large public sector share of output (about 40 percent of GDP, high relative to Croatia's peers in central and eastern Europe). While recent progress in some transition indicators has been significant, Croatia still lags behind in privatization and the restructuring of state-owned enterprises. Besides survey evidence, our discussions consistently indicated that the conditions for doing business could be significantly improved, with considerable emphasis placed on problems at the local level. Against this background, the mission's estimates suggest potential growth of about 4½ percent, or somewhat lower. The implication is that without further measures, growth is unlikely to exceed this rate on a sustainable basis, slowing convergence.

Fiscal Policy

5. Reducing the size of the government, undertaking further fiscal consolidation, and enhancing the flexibility of fiscal policy are three essential and interrelated aspects of fiscal policy. The importance of undertaking these actions is motivated by (i) the opportunity to boost economic growth by reducing the large size of government; (ii) the importance of addressing a large current account deficit and ensuring a sustainable debt path; and (iii) with monetary policy focused on exchange rate stability, the benefits of enhancing fiscal policy flexibility to cope with shocks.

6. The government's overall fiscal strategy-including the targets for 2006 and 2007-represents an important step in the right direction. This strategy was described in Economic and Fiscal Policy Guidelines for the Period 2007-09, approved in July 2006. It targets a reduction in the fiscal deficit from the budgeted 3 percent of GDP in 2006 to 2.8 percent in 2007, gradually declining to 2.4 percent by 2009. This adjustment is based on ongoing structural reforms (in the areas of pensions, health, and subsidy reduction), and on a continuation of the expenditure restraint practiced since 2004.

7. However, potentially serious concerns arise with respect to fiscal policy in 2007.

• Spending pressures are mounting. The recently approved increases of child and maternity benefits and free school textbooks add to expenditure at least 0.3 percentage point of GDP. More importantly, pressures to raise budgetary wages by more than the 5 percent envisaged by the authorities, and boost pensions of post-1999 pensioners represent sizable fiscal risks.

• While achieving the 2007 deficit target of 2.8 percent of GDP would no doubt be an accomplishment in the politically-charged atmosphere before elections, problems would be created in the out years if exceptional, temporary revenue increases (including, for example, a large CNB profit transfer, and dividends from state enterprises) were to be used to fund additional, permanent expenditure commitments.

• In addition, other planned activities of a fiscal and quasi-fiscal nature add to aggregate demand pressures at a time when the current account deficit has been widening. This includes the scheduled "pensioners' debt" payments (1.1 percent of GDP), the plans of the Croatian Bank for Development and Reconstruction (HBOR) to raise its deficit from an expected 0.2 percent of GDP in 2006 to 0.6 percent in 2007, and potentially large borrowing by shipyards using government guarantees (up to 1.6 percent of GDP).

8. The mission sees considerable merit in stepping up the fiscal adjustment effort.

• For the near term, the mission recommends adhering to the expenditure-to-GDP ratio envisaged in the July 2006 medium-term framework and saving any revenue overperformance: doing so would avoid a ratcheting-up of spending that could make fiscal adjustment more difficult in later years. At the same time, HBOR should reconsider the planned expansion of its lending and external borrowing. It goes against government efforts to reduce public spending and foreign debt.

• Looking further ahead, the mission recommends more ambitious fiscal deficit targets of 2 percent of GDP in 2008 and 1½ percent in 2009. In addition to helping rein in the current account deficit, this is because: the policy recommendation would provide needed insurance against negative surprises; frontloading measures at the start of the next government's terms would be beneficial in light of the usual pressures from the election cycle; a strong fiscal position helps create room for an increase in expenditure related to absorbing the structural funds and paying Croatia's contribution to the EU budget; and, with the authorities aspiring to join the EU in 2009 and enter ERM-2 fairly quickly, a strong fiscal position adds to the credibility of their euro adoption strategy.

• To enhance fiscal flexibility, the authorities should consider raising gradually the general contingency to about 1 percent of central government expenditure (from about 0.3 percent in the past). It would also be important to have contingent fiscal policy measures in hand in case the deficit needs to be reduced at short notice.

9. To be successful, the medium-term adjustment effort must focus on permanently reducing expenditure. With an expenditure-to-GDP ratio well above peers (49 percent of GDP in 2005 compared with an average of 40½ percent for peers) significant savings are possible-savings that would enable both tax cuts to boost growth and a lower budget deficit.The mission therefore urges further fiscal structural reforms in several areas including: (i) a civil service reform that would allow more flexibility and sharper performance-based differentiation of individual wages, while keeping the overall compensation cost on a declining path by reducing-rather than expanding-the high public sector employment; (ii) further progress in implementing the adopted health reform strategy, after the encouraging steps taken in 2005-06, aimed at providing incentives to both suppliers and users of medical services to reduce costs and arrears that have been symptomatic of the problems in this sector. In this regard, the authorities' intentions to shift financing to a per-diagnosis basis in hospitals as well as strengthen control over sick leave spending are well placed; (iii) better targeting of welfare, family, and health benefits that takes into account the income (and assets) of recipients, and consolidation and simplification of the numerous welfare benefits. The work of the interministerial working group in this area is an important first step and further expansion of the scope of its activities would be welcome; and (iv) full implementation of the existing medium-term subsidy-reduction plan, especially as regards the railways, and the forthcoming shipyard restructuring plan.

10. The mission is encouraged by the authorities' recognition of the importance of transparency and fiscal controls to avoid contingent liabilities coming to roost. In particular, it supports the Ministry of Finance's determination to keep to a minimum the amount of guarantees extended to the shipyards before their restructuring plan is put in place, as most of these guarantees are likely to be called. Moreover, the broader use of public-private partnerships (PPPs) requires safeguards ensuring that the private partner takes the construction and demand risk, with a view to avoiding unexpected government expenditure. In this regard, the "gatekeeper" role of the Ministry of Finance in assessing PPP projects before they commence is crucial.

11. Strong arguments can be made for consolidating HBOR's activities within the general government-at a minimum, its activities need to be consistent with fiscal policy goals. HBOR is a fully government-owned entity, implementing public policy objectives through its lending. It is financed mostly by government-guaranteed external borrowing and budget transfers; it is exempt from corporate income tax; its activities are not supervised by the central bank and are not subject to the same prudential requirements as private commercial banks; and its operations create considerable contingent liabilities for the budget. Its activities are therefore part of the government sector and need to take into account the country's macroeconomic constraints, even if HBOR may have a role to play in reaching some financially constrained market segments or channeling official funds into Croatia.

Monetary Policy and the Financial Sector

12. The CNB's present monetary policy framework continues to contribute to macroeconomic stability. For several years, the CNB has targeted a broadly stable kuna-euro exchange rate as the predominant operating objective of monetary policy, while allowing moderate exchange rate fluctuations to accommodate seasonal market pressures. This framework is appropriate, particularly because of extensive euroization: about 80 percent of bank loans and time deposits are foreign-currency denominated or indexed. Crucially, the framework has delivered consistently low inflation, fulfilling the CNB's primary objective.

13. Nevertheless, the tightly managed float has implications for other policies. Limited exchange rate flexibility is conducive to unhedged borrowing in foreign currencies with potentially negative implications for financial stability, an important area of focus for supervision. Furthermore, the constraints on monetary policy put considerable onus on fiscal policy. Given the high level of euroization, the adverse impact of a weaker exchange rate on balance sheets would likely offset any short-term gain in competitiveness. This implies no quick fixes: faster and deeper structural reforms, along with wage moderation, are the only way to strengthen competitiveness so Croatia can catch up to top performers in central and eastern Europe in terms of export growth.

14. Continued deepening of the financial sector has been accompanied by strong performance, particularly by banks. Banks, which account for about 80 percent of total financial sector assets, continue to be well capitalized and profitable, and efficiency has been improving. Moreover, the share of nonperforming loans in total loans has been trending downward, though this is usually the case when credit is growing rapidly. In funding rapid credit growth, the banks have engaged in significant foreign borrowing. This has mostly been at variable interest rates, exposing banks to some income risk if foreign interest rates rise sharply. The growth of nonbank financial sector assets has also picked up in recent years, especially that of leasing companies, and investment and pension funds. The recent surge in stock prices appears to have been driven mainly by the strong demand of institutional investors in a thin market.

15. Financial vulnerabilities that have arisen are related in particular to rapid credit growth. Several intertwined concerns go hand in hand with the vigorous expansion of domestic credit: Croatian residents are building up net liabilities that are sensitive to changes in exchange and interest rates; notwithstanding stiff bank competition, higher foreign interest rates may eventually prompt increases in domestic lending rates and a deterioration in the debt servicing capacity of Croatian firms and households; with loans to firms and households denominated in or indexed to foreign currency and largely unhedged, banks are exposed to foreign-currency-induced credit risk which may well be high; and the experience of other emerging markets shows that credit assessment standards tend to be relaxed in the face of strong competition and booming demand, making banks more vulnerable if buffers are not built in advance.

16. The authorities recognize these vulnerabilities and are taking steps to address them. The CNB has recently taken a number of appropriate measures aimed at improving banks' management of credit risk: increasing risk weights on unhedged foreign-currency denominated and indexed loans, introducing quarterly reporting requirements for such loans, and issuing new guidelines to banks on managing household and currency-induced credit risk. In addition, the mission commends the upcoming establishment of a credit bureau, the steps in train to include nonbank debt, and the CNB's guidelines that rightly envisage higher risk weights for loans not involving the credit bureau. Continued vigilance will be needed in monitoring emerging risks and ensuring that adequate risk management practices are in place, including those related to surging real estate prices. In order to encourage banks to reduce their reliance on foreign borrowing, the CNB tightened prudential requirements this year (for example, it raised the marginal reserve requirement and broadened the base of the foreign-exchange liquidity requirement). Banks appear to be changing their behavior in response, which could lead to a welcome moderation in credit growth. But if they continue to extend credit at its present, high, pace, the CNB may need to consider further measures.

17. The framework for nonbank financial sector supervision has improved substantially. A notable recent development that broadens financial sector supervision is the establishment of the unified nonbank supervisor (HANFA). Its financing with fees from supervised entities helps ensure its independence, and the overall increase in its resources is allowing it to conduct a broader range of supervisory activities, a process that needs to continue. Close cooperation between HANFA and the CNB-facilitated by a memorandum of understanding-is welcome. The draft Leasing Act intends to clarify that HANFA has oversight of leasing companies and to prevent these companies from extending new non-leasing credits. These would be positive developments, including by closing a loophole for escaping the CNB's reserve requirements.

Structural Policies

18. The mission's discussions highlight the urgency of measures to improve the business environment and remove bureaucratic obstacles to economic growth. A broad range of public and private sector representatives consistently identified the main obstacles to doing business in Croatia as the administrative burden, notably at the local level; and property-related legal uncertainties, specifically land ownership issues and enforcement of property rights. Important steps have already been taken to simplify procedures at the central government level, for example the hitro.hr service featuring a "one-stop shop" to establish a business; "entrepreneurial zones" with good infrastructure and land free of ownership uncertainty; and the initiation of a "regulatory guillotine" to eliminate unnecessary regulations. But at the local government level, investors often face uncertainties and delays in obtaining necessary permits and numerous and nontransparent fees. Complex local government regulations are also seen by various sources as conducive to corruption. Despite recent efforts to clear a judicial backlog, bankruptcy and contract enforcement procedures remain very slow. Survey evidence also suggests that, despite some relaxation in 2003, strict employment protection legislation remains a disincentive to new job creation.

19. The authorities should persevere with their long-standing reform agenda for remaining state-owned enterprises. The troubled shipyard sector continues to consume a disproportionate share of public resources. Thus, the finalization of a national restructuring plan to make the sector commercially viable, before the current "one-time, last-time" rescue package expires in March 2007, is essential. Difficult decisions to rationalize capacity and employment are inevitable. In view of past delays, every effort needs to be made to complete the privatizations of the two large steel mills by end-2006. The mission welcomes the forthcoming launch of the initial public offering for INA (the national oil company), looks forward to the third phase of privatizing HT (the telecom company), and urges the sale of all other shares held by the Croatian Privatization Fund as soon as possible.

20. The mission has strong reservations about aspects of the new draft privatization law. The mission supports the envisaged steps to simplify privatization procedures without loss of transparency. But it is concerned about the planned employee stock ownership program (ESOP)-in particular that a too generous ESOP component would risk deterring potential strategic investors and entrenching insider control of enterprises, thereby worsening corporate governance problems and limiting the possibility for new investment. This may still allow the process of privatization to take place, but would largely defeat its purpose.

21. A further task for policymakers is to convince the public of the benefits of FDI. Recent opinion polls reflect considerable public anxiety about foreign investment. Greenfield FDI into central and eastern European countries that recently joined the EU has been key to their dynamic export performance, with large positive spillovers to other sectors of their economies. While privatization-related FDI inflows have been large in Croatia, greenfield FDI has been low. Croatia now has good prospects to attract more greenfield FDI, especially if business conditions improve: the regional instability in the 1990s has eased and the EU accession process is moving ahead. But unwelcoming attitudes toward FDI would still deter investors, curtailing Croatia's potential growth and living standards.

In Closing

22. The authorities recognize well the challenges that lie ahead and understandably want to raise the potential growth rate of the economy while minimizing vulnerabilities. With the Stand-By Arrangement expiring, the authorities have the opportunity to cement policy credibility by moving forward decisively with fiscal consolidation and much-needed and overdue structural reforms. The policy successes in recent years and the beginning of the EU negotiations have attracted investors' attention. But the importance of creating a business-friendly environment that will turn investment interest into actual projects and create new jobs-thereby improving living standards-cannot be emphasized enough.

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We very much appreciate the open and high-quality discussions we have had with the Croatian authorities and other public and private sector representatives. We would like to thank them all for the time and effort they put into the Article IV consultation.